Pension investment involves setting strategic asset allocation, or long-term target weights to meet the investment objective of a pension scheme. These target weights are set with their corresponding risk and return characteristics, but overtime these target weights drift because different asset classes have different expected returns.

If the initial investment target hasn’t changed, the portfolio must be rebalanced to ensure that the portfolio’s risk and return characteristics remain consistent over time. Importantly, portfolio rebalancing also prevents the portfolio from drifting to unintended risk territories, caused by increases in the value of risky asset classes.

Rebalancing back to the target weight involves reducing the over weighted asset class and increasing the underweighted asset classes. This involves selling the overweight asset class and buying the underweight asset class.

Take an asset weight of equity and bonds of 50/50 split. As equity values increase, so will the allocation of the scheme – this could drift to 55/45 or 60/40, and in a down market it could drift to 45/55.

If we take the target weights as the most appropriate to meet the long-term needs of a pension scheme based on the most current market conditions, then any divergence from this target will be undesired. Therefore the scheme must be rebalance back to 50/50 in response to the fluctuations.

To rebalance back to the target allocation, we need to make a decision about how far we are willing to allow for the target allocation to drift before we rebalance. This will require setting boundaries or trigger points around the target allocation.

For example, if the target proportion for the asset class is 70 percent of portfolio value, then the boundaries could be 65% or 75% of portfolio value. We could say that 65% to 75% (or 70 +/- 5%) is the tolerance band. The portfolio is then rebalance when an asset class’s weight first goes over any one of the boundaries – either the upper or lower boundary.

For rebalancing to be effective, it requires monitoring at an agreed frequency, usually daily, to identify instances in which a boundary or trigger is breached. Daily monitoring will also requires an efficient team, who can monitor, quickly implement, and communicate any rebalancing when any of the boundaries are breached.

How then do you determine how wide or narrow these boundaries or triggers should be?

At least four key factors should play a role in determining the boundaries around the target allocation. These are:

Transaction cost;

Risk tolerance;

Correlation;

Volatility;

Transaction Cost – the boundaries should be set wider, the more expensive it is to buy and sell the asset class. This is because narrow boundaries will involve frequent trading due to fluctuations in the asset prices, which may offset any market gains. Therefore a wider boundary will minimize the impact of expensive trading costs.

Risk tolerance – refers to the ability or the willingness of the pension scheme to bear risk. Higher risk tolerance means less sensitive to deviations from the target weights, therefore the wider the boundaries should be when rebalancing are considered.

Correlations among the returns of asset classes mean that they tend to move together. And when asset classes move together, further divergence from the target weight is less likely, reducing both the risk of significant deviation from the target allocation and the need to rebalance. Therefore the more correlated the asset classes, the wider the boundaries around the target weights.

Volatility – high return volatility increases the fluctuation of the asset class weighting around the target allocation and increases the risk of significant deviation from the target. As such greater volatility implies a greater need to rebalance.

It even hurts more for a portfolio that is currently off target for a more highly volatile asset class, because it has a greater chance of a further large move away from target.

For these reasons higher volatility should lead to narrower boundaries.

As you can see, rebalancing becomes important if a pension portfolio is to maintain its risk and return profile, and to be on track to meet its long-term investment objective.

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